What does one Rupee absorption of oil price by OMCs mean and how does it impact their profits?

Most oil marketing companies (OMCs) have given up huge gains in the last couple of months. In fact, stocks like HPCL, BPCL and IOCL have lost close to 40-50% from their peak values in a short span of time. This correction came immediately after the government asked the OMCs to take 1 Rupee hit on their profit margins to help keep the price of petrol and diesel low. The government will also participate in the cost-cutting by foregoing part of its excise duty while the state governments had been requested by the central government to absorb part of this cost by reducing the VAT. First a background to this entire debate!

From controlled pricing to free pricing

One of the reasons why stocks like HPCL, IOCL and BPCL outperformed in the 3 years post-2014 was the gradual freeing up of petrol and diesel and bringing in free pricing. Now, these oil marketing companies are free to reset their price on a daily basis depending on the price of the crude import basket movement. Interestingly, since the beginning of 2015 when the prices of crude were falling sharply, the government skimmed away most of the fall in the form of higher excise and customs duty. Thus, only part of the lower price benefits actually got passed back to the consumer. Under the free pricing regime, the downstream oil companies were permitted to pass on their cost increases proportionately to the end consumer. There was no government involvement.

Then, where did the problems start?

The free pricing was acceptable for people till the time the prices were within control. Once petrol got closer to Rs90/litre it was a case of all hell breaking loose. Families saw their monthly fuel budgets going awry and the family budgets also got impacted by the downstream impact of inflation. As a result, the government had to intervene to quell the prices. In the past, at least 2014, the government would regulate the price of petrol and diesel and after a point the public price would be regulated and the rest of the losses would be absorbed by the OMCs. Of course, this was only a temporary parking of losses as the government would issue oil bonds against these outstanding amounts, which would be automatically defrayed after the prices came down to normal levels. With the NDA government’s latest announcement about passing on a part of the burden to the OMCs, it looks the old days are back again. That is what is hurting these stocks so much. But let us look at the impact of the move in financial terms.

How big would the impact on OMCs?

According to a press release put out by CRISIL, the total impact on the 3 downstream oil companies viz. IOC, HPCL, BPCL would total to Rs.3,500 crore on an average. Please note that this is the impact of Rs.1 cost imposed on the books of the OMC. That is of course assuming that the price of crude does not go up much further from here and the rupee does not depreciate too much versus the dollar, in which case, the damage could be a lot bigger. And, of course we are not yet factoring in the impact of under-recoveries in LPG and kerosene.

As per the announcement, central excise duty on the two fuels has been slashed by Rs 1.50 per litre, while Re 1 per litre will have to be absorbed by the OMCs in their marketing margins. The Center has also appealed to states to reduce the value-added tax (VAT) levied by them by a further Rs 2.50 per litre. As of now, it is more of the BJP ruled states that have obliged with a cut, not the other states. The move is aimed at providing some respite as petrol and diesel prices have skyrocketed over the past couple of months with crude oil prices touching a high of $86/bbl mark. As things stand, average gross marketing margins of the OMCs on diesel and petrol have come off from Rs.3 per litre in the fourth quarter of 2017-18 to Rs.2.60 per litre in the second quarter the current fiscal due to the uptrend in crude prices.

Therefore, the Re 1 per litre hit will shave 100-130 basis points off the OMCs’ operating margins and result in an Rs.3,000-3,500 crore of reduction in operating profits this quarter. The overall drop could be about 15% in this quarter and a further 18% drop in the next quarter as well, assuming the government decides to extend the marketing margin hit. There is a bigger problem for oil market companies to contend with. The ballooning crude oil prices are estimated to push up the under-recovery burden on LPG and Kerosene to Rs.47,000 crore. The government has provided only Rs.25,000 crore in this budget, so that the balance of Rs.22,000 crore may also fall on the OMCs. That is certainly a bigger worry for these oil marketing companies.